Determinacy and Identification with Taylor Rules

John Cochrane

No 13410, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The new-Keynesian, Taylor-rule theory of inflation determination relies on explosive dynamics. By raising interest rates in response to inflation, the Fed induces ever-larger inflation or deflation, unless inflation jumps to one particular value on each date. However, economics does not rule out inflationary or deflationary equilibria. Attempts to fix this problem assume that people believe the government will choose to blow up the economy if alternative equilibria emerge, by following policies we usually consider impossible. Therefore, inflation is just as indeterminate under "active" interest rate targets as it is under fixed interest rate targets. If one accepts the new-Keynesian solution, the parameters of the Taylor rule relating interest rates to inflation and other variables are not identified without unrealistic assumptions. Thus, Taylor rule regressions cannot be used to argue that the Fed conquered inflation by moving from a "passive" to an "active" policy in the early 1980s.

JEL-codes: E3 E31 E52 E58 (search for similar items in EconPapers)
Date: 2007-09
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: EFG ME
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Citations: View citations in EconPapers (26)

Published as John H. Cochrane, 2011. "Determinacy and Identification with Taylor Rules," Journal of Political Economy, University of Chicago Press, vol. 119(3), pages 565 - 615.

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